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Bond-Friendly Environment Driving Tax-Aware Investor Demand For Munis

Summary

State and local governments picked up the pace of bond sales in August.

Investors have looked to increase their allocations across fixed income classes this year.

For individuals in high tax brackets, we think municipal bonds can be a good option.

State and local governments picked up the pace of bond sales in August, taking advantage of attractive financing at low rates. In a far more bond-friendly environment, investors have looked to increase their allocations across fixed income classes this year. For individuals in high tax brackets, we think municipal bonds can be a good option. Here's why.

Tax-equivalent yields are still attractive despite falling rates

With the significant rally in bond prices - especially after the US Federal Reserve (FED) moved to an easing stance at the July policymaking meeting - munis have followed the same path to lower rates as other income assets. According to Bloomberg, a 10-year A-rated muni bond yielded about 1.45% at the end of August. For those in the highest bracket taxed at 37%, the tax-equivalent yield around 2.3% continues to be more attractive than other high-grade fixed income alternatives like Treasuries.

SALT deduction cap motivates home-state investing

As part of the U.S. tax reforms in 2018, state and local tax (SALT) deductions were capped at $10,000. So for anyone living in California, New Jersey and New York - with state income tax rates as high as 13.3%, 8.97% and 8.82%, respectively - the effective tax rate has gone up. Investing in state-specific bonds can provide some relief to residents looking to lower their tax burdens.

Credit research helps to avoid potential default risk

Generally speaking, munis have exhibited low default rates, but the muni market is quite nuanced, with 50,000 different issuers - a far cry from the corporate bond market. While we may not hear as much about an impending wave of muni defaults as we did after the global financial crisis, there are still good reasons to be cautious.

Even 10 years into an economic expansion, certain states and cities continue to face challenges, including unfunded pension liabilities and high debt levels. In California's case, the state economy is tied to the US business cycle because of the heavy reliance on personal income taxes in the revenue stream. When times are good, revenues can go through the roof. But when the economy slows, California tends to see a massive downshift in revenues, and its credit ratings can take a hit.

That's why we believe that professional management can be really important for taxable investors. Our credit analysts are doing the appropriate due diligence, in addition to the public ratings - helping to steer away from riskier issues prone to downgrades or even uncovering opportunities in the muni market.

Bottom line: August was the strongest month for muni debt issuance so far this year, and we expect that pace to continue. More robust demand has met the higher supply, but prudent investors still need to consider the credit worthiness of their muni bonds and position accordingly.

Investing involves risks including the risk of loss. An imbalance in supply and demand in the municipal market may result in valuation uncertainties and greater volatility, less liquidity, widening credit spreads and a lack of price transparency in the market. There generally is limited public information about municipal issuers. In general, the bond market is volatile. As interest rates rise, the value of certain income investments is likely to decline. 

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.